Over the past few years, the overall economic outlook has been precarious, to say the least. Downward pressure on consumer spending and sentiment has forced financial managers to redefine their assessments of financial results. For some organizations, the stigma of break-even results has shifted from troubling disappointment to modest achievement. In such a volatile environment, not-for-profit boards should be asking: what can we do now to avoid trouble later? The simple answer is that every not-for-profit organization should establish, fund, monitor, and use operating reserves to manage and minimize risk. But, exactly how much should be set aside as reserves?
Operating reserves are essentially funds set aside to overcome lean financial times and unexpected, unfavorable events. Generally, operating reserve funds consist of current, short-term net assets. In arriving at which funds make up an operating reserve, short-term is defined as zero to three months and long-term is defined as beyond three months. The most often used formula is current, short-term assets (including cash, cash equivalents, accounts receivable, and inventory), less prepaid expenses, less current liabilities, plus investments, plus deferred revenue.
In a cash crisis, the availability of operating reserves provides a practical and often preferred alternative to opening a line of credit, soliciting emergency donations, or selling off capital assets. Operating reserves act as a "rainy day fund," a cushion to stabilize short-term cash flow fluctuations. Minimizing the effect of cash shortfalls ensures that an organization can overcome missed financial projections and poor economic conditions while maintaining essential programs and long-term strategic goals.
Unfortunately, the most straightforward response as to how much not-for-profit organizations should keep in operating reserves is "it depends." While there is no "one-size fits all" approach to benchmarking a reserve, there is a consensus about what an organization must target as a minimum reserve, which should be no lower than three months of operating expenses. A recent survey of 25 national trade and individual membership associations, conducted by Raffa, Inc., found that the median operating reserve was between three and four months of operating expenses. The results show that organizations are merely meeting the industry baseline. Ideally, an organization should target for a reserve above the baseline. The projection depends, therefore, on a case-by-case evaluation of each organization's unique set of facts and circumstances.
The following factors should be evaluated when developing a reserve target benchmark:
Two approaches to developing a target reserves benchmark are discussed below.
1. Comparative, Qualitative Approach - You Know Your Organization Best
Under the comparative approach, after obtaining an understanding about key organizational facts and circumstances, the board weighs the above factors and makes a subjective determination about what operating reserve target is appropriate. The board should project its target from the three-month operating reserve baseline. For example, an organization that relies heavily on annual membership renewals, which are received at the beginning of the year, may expand its operating reserve target to six months of operating expenses because this intermittent revenue stream results in low cash positions during the year. An organization should ensure that it manages risk to make it through every cash cycle.
2. Contingency, Quantitative Approach - Murphy's Law
Under the contingency approach, the board must brainstorm and identify future capital requirements, possible unplanned events, and potential strategic opportunities. Generally, the board should identify items outside of the ordinary operating budget. Then, the board should consider the relative likelihood of occurrence of these events, along with a projected financial impact. By multiplying the likelihood of occurrence by the projected financial impact of such events, an organization can project the operating reserves needed over a certain time period, above and beyond the minimum three-month operating expense target. For example, an organization with a concentration of income on a few large members may lead the board to assess the potential loss of a member. The board should then determine the likelihood of the loss and the financial impact of the loss. The loss projection should be included in the organization's assessment of its operating reserve target.
Regardless of the approach used, an organization should have an operating reserves policy in place to specify target levels, funding options, use criteria, and board responsibilities. Options for funding a reserve include earmarking one or more of the following inflows: percentage of annual gross income, net operating surplus (or a percentage thereof), large contributions, net investment income, etc. Balancing the need for building a reserve with the importance of continually providing essential services to its stakeholders is a challenge, admittedly. If an organization decides to build its operating reserves, an open and clear message about its strategy may help avoid potentially negative reaction from stakeholders, such as members and contributors.
To help monitor a reserve, the best practice is to classify operating reserve funds as board-designated, unrestricted net assets. Classification as board-designated offers the advantage of a clear presentation of reserves in the general ledger and on the statement of financial position. Therefore, the board may easily monitor and control their use.
Also, the operating reserves policy should set forth the investment options and strategies for reserve funds. Corresponding with the scope of the reserves target, the policy should specify what liquidity, maturity, and risk levels are appropriate. For instance, if an organization sets up a twelve-month operating expense target, the organization may want to place half its reserve into highly liquid, low-risk securities and half into less liquid, higher risk securities to maximize returns.
Without a doubt, effective planning is the most important aspect of developing an operating reserve. Do it as soon as possible. A little forethought now can go a long way later.
For additional reference, see the National Center for Charitable Statistics' Operating Reserve Policy Toolkit for Nonprofit Organizations. See also websites for the Urban Institute, Guidestar, and National Council of Nonprofits. For business model and reserve policy templates, see the National Center for Charitable Statistics and the Nonprofits Assistance Fund.
By Mike West, CPA, Supervising Senior, mwest@legacycpas.com